More thoughts on rethinking risk

A few weeks ago, I wrote a column, “The necessity of strategy,” about a concept postulated by Invesco, a large money manager. The concept, rethinking risk, is based on five myths, truths and actions. That column dealt with the first set of myths, truths and actions.

This column is about the second set:

Myth: Missing the market’s best days is the worst thing I could do to my portfolio.

Truth: The market’s worst days are just as important as its best days (and maybe even more).

Action: Remain invested, but seek to avoid catastrophic losses.

For years, conventional investment wisdom encouraged investors to stay invested over time and avoid market timing strategies so that they wouldn’t miss out on the market’s top performance days. Investors were warned that missing the “10 best days” would drag down the value of their portfolios; however, that idea is only part of the story. It glosses over the risk of staying invested during the markets worst days.

As it turns out, over the past 83 years, the markets worst days have far greater effect on portfolio return than the market’s best days. Clearly, it’s time to rethink the conventional wisdom of pursuing returns without considering the risks involved.

In “A Tale of Two Cities,” Charles Dickens wrote, “It was the best of times, it was the worst of times.” Although Dickens did not have the stock market in mind when he wrote this famous line, investors can use this message as a good reminder: There are two sides to every story.

The market’s “best of times”: The S&P 500 Index’s 10 best performance days over 83 years (1927-2010) yielded an average daily return of 11.68%. The market’s “worst of times”: The 10 worst performance days across those same 83 years, provided an average daily return of negative- 10.84%. The problem of focusing on only half of the story is that it emphasizes the effects of the best days while ignoring the effects of the worst days. So what lesson can investors take away from these numbers?

Let’s take a look at the whole story.

During those 83 years, a $1 investment would have grown to $71.21 under a buy-and-hold strategy that captured the performance of each and every day, including the 10 best and 10 worst days. Obviously, missing positive performance won’t help improve returns. If you missed the 10 best days of the market performance in those 83 years, $1 would have grown to only $23.89, about one-third of the growth of the entire period. Looking at the whole story, however, shows that missing the 10 worst performance days improves returns dramatically, a $1 investment would’ve grown to $228.71, more than tripling the overall $71.21 growth from 1927 to 2010, and underscoring the importance of downside risk management.

What if we avoided the extremes altogether? Missing the 10 best and 10 worst days would have resulted in the return of $75.01 on a $1investment. That’s $3.80 more than the returns of a buy-and-hold strategy with less volatility.

Lastly, if you avoided the market altogether and stayed in cash, you’d have $19.31 after 83 years.

The numbers show that relying on pinpoint trades isn’t the most effective strategy, but, depending on your time horizon, a buy-and-hold strategy may not work either. So what’s an investor to do? Like all good stories, there’s a moral for this one: Your first investment priorities should be to minimize risk, not maximize returns. We now know the market’s worst days have had a bigger effect on market returns than the market’s best days. Let’s examine why, and what that means for investors who don’t plan on staying in the market for eight decades.

As a portfolio loses value, the needed returns to breakeven – that is, to make up the losses – grow substantially. Here are some examples:

• A 10% loss requires an 11percent gain to break even.

• A 25% loss requires a 34 percent gain to break even.

• A 50% loss requires 100 percent gain to break even.

It is important to remember that individual risk isn’t measured as much by volatility as it is by the potential to miss investment goals. In other words, if your goal is retirement, your risk tolerance may be better defined by your ability to retire according to your plan than it is by your ability to tolerate a 20% swing in market performance. That means your financial plan should be designed first and foremost to meet your retirement goals, not to capture the market’s best of times.

Past performance is no assurance of a future result. The market for all securities is subject to loss.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann, CFP® is a registered representative with and securities and insurance offered through LPL Financial. Member FINRA/ SIPC. He can be reached at 600 East Crescent Avenue, Suite 104, Upper Saddle River, NJ 07458, 201-291-9000.

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